Winning preferred fund bets on real estate

NEW YORK Wed Dec 4, 2013 1:34pm EST

Traders work on the floor of the New York Stock Exchange December 3, 2013. REUTERS/Brendan McDermid (UNITED STATES - Tags: BUSINESS)

Traders work on the floor of the New York Stock Exchange December 3, 2013.

Credit: Reuters/Brendan McDermid (UNITED STATES - Tags: BUSINESS)

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NEW YORK (Reuters) - Portfolio manager Joel Beam has spent the last 13 years investing in a part of the market that even many professional investors aren't familiar with. Now, his specialty is becoming mainstream.

As the lead manager of the $1.5 billion Forward Select Income fund, Beam focuses on preferred shares, a type of stock that essentially blends the share price movements of common stocks with the fixed interest of bonds. Investors who buy preferred get a small percentage of the stock moves and dividends, which have substantially higher yields than Treasury bonds.

Even though Beam's fund has returned an annualized 9.5 percent over the last three years -- well above the 3 percent annualized gain of bond fund mainstays such as the Vanguard Total Bond Market index fund -- Forward Select has traditionally received little attention from financial advisers and investors because preferred shares do not offer the same protection as bonds in the event of a bankruptcy.

Yet with bond yields stuck near record-low levels after years of the Federal Reserve's bond-buying stimulus program, income-hungry investors have been lured by preferred yields that often top 6 percent, well above the approximately 2.5 percent yield of the Barclays Aggregate U.S. bond index. There are now 41 preferred funds tracked by Morningstar; 10 years ago there were only five, including the Forward fund.

Beam takes his specialty one step farther than most managers in the $300 billion preferred market: he invests primarily in preferred issued by real estate investment trusts (REITS), a slice of the market that he estimates at just $25 billion.

Though a small part of the preferred market, REIT preferred are more attractive than those issued by financial companies because they have a greater degree of transparency, Beam said.

"We've obviously learned over the past five years that you can't really see under the hood of a bank balance sheet. You are putting a great deal of trust in management that everything is as they say it is," Beam said, citing hefty fines leveled on JPMorgan Chase, Citigroup and other financial firms, and suggesting the REITs are safer bets.

What's more, preferred issued by REITs are almost all cumulative, Beam says, meaning that, should a company decide to suspend the dividend payment on its preferred shares, it must repay all of the missed preferred dividend payments once it resumes paying any stock dividends. Dividend-paying common stocks do not offer the same guarantee.

Still, there are risks to his approach on the fund, which has the second-best performance among the 30 funds in his category over the last three years. (Institutional shares of the same fund, which require a $100,000 minimum investment but have slightly lower fees, are the top-performing share class in the category with a 9.8 percent annualized return.)

Because the market is so small, REIT preferred do not trade as frequently as either traditional stocks or bonds, making it hard to sell shares quickly should something go wrong. Most preferred funds are also so new that most fund tracking firms like S&P Capital IQ do not rate them. Influential fund tracker Morningstar started its preferred share category in mid-November, though many of the funds have no analyst rating yet.

Moreover, Beam's strong track record doesn't come cheap. Investors pay an annual fee of $1.54 per $100 invested, a level Morningstar considers high, and some shares charge a sales load of 5.75 percent.

The $2.3 billion Cohen & Steers Preferred Securities and Income fund, whose performance is slightly below Beam's, charges 75 cents per $100 invested, a level Morningstar considers low.

FOCUS ON HOUSING

Though the area of the market he focuses on may be small, Beam follows a process similar to a value fund manager.

For all of the 80 companies in his portfolio, he has searched for firms with high levels of cash flow that trade at a discount to what he considers their intrinsic value. More than 90 percent of his holdings are REITs, according to Morningstar data.

He owns preferred shares of data center company Digital Realty Trust, for instance, because it trades at a discount to the company's breakup value. The shares yield 7.4 percent.

"Buying this makes sense all day long," Beam said.

Lately, Beam has been looking to move more of his portfolio into multi-family housing REITS, which currently make up about 9 percent of assets, but without much success.

"I wish multi-family was the largest part of our portfolio because it happens to be a really great business. But it tends to have lower yields and premium pricing," he said.

Instead, he has been adding to the approximately 20 percent of his portfolio in retail holdings. He's been buying preferred shares of Agree Realty Corp, a REIT that owns shopping centers in states such as Florida, Kentucky and Michigan, and standalone buildings leased to tenants including Applebees and Lowe's. The shares trade at a yield of 4.5 percent and should benefit from the continued rebound of the U.S. housing market, Beam said.

He's also been looking into buying preferred shares of Equity LifeStyle Properties Inc, a REIT that manages mobile home parks and retirement communities in 32 states. The preferred shares yield 7.2 percent, Beam said, and are in a stable business line. Yet he's waiting for the price to fall a little further before he buys in.

Beam has been shying away from preferred shares of REITS in the self-storage business because he "can't get the price we want," he said. His fund currently has no holdings of self-storage REITs.

(Reporting by David Randall; editing by Linda Stern and Leslie Adler)

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